Bull Market

June 11, 2007

The private stock exchange that could revolutionize the U.S. financial system

The virtue of stock markets, at least in theory, is that anyone can participate--and, through them, come to own a piece of corporate America. Free marketeers like to hype widespread stock ownership (over 50 percent by some counts) as a keystone of social stability, economic vitality, and political participation. And, while such claims should be taken with a fat grain of salt--owning part of a company hardly gives you a voice in running it, most people own stock indirectly through pensions or mutual funds, and so on--they're basically right. Buying stock in a company means buying into the economic and political systems that make it possible.

That's how thing are supposed to work. But, last month, Goldman Sachs unveiled a new system that effectively cuts out individual investors--and regulatory oversight--from the process of buying and selling stock. Called Goldman Sachs Tradable Unregistered Equity (GS TrUE), it is a private electronic exchange in which companies can sell unregistered shares of themselves to a coterie of high-end investors (almost exclusively institutions, such as pensions and hedge funds). Eventually, it will become a full trading platform, meaning it would work just like the New York Stock Exchange or NASDAQ--but, being private, its participants could largely avoid Securities and Exchange Commission (SEC) oversight. Thus, companies on GS TrUE will have it both ways: They won't have to release information about themselves or abide by most SEC rules, but they can still tap into a good-sized chunk of U.S capital pools.

So far, Goldman has debuted only one company (fittingly, a private-equity firm), but the system's performance so far has other banks, and even NASDAQ, eager to follow its lead. And, while few expect such private exchanges to supplant public markets, their free-lunch appeal could easily become a major alternative. If it does, it will revolutionize the U.S. financial system. And, in an economy supposedly built on the tight relationship between individuals and markets, that's bad news--not least for the corporate world itself.

As the Wall Street Journal declared, GS TrUE "represents the latest step in the creeping exclusion of individual investors from a growing proportion of financial-market activity." That includes hedge funds, which exclude all but the richest individuals, and private equity, which buys public companies and takes them private. But hedge funds are, in many ways, just another player in the public markets, and private equity only makes a profit when it returns privatized firms to the public markets.

GS TrUE changes that equation by creating a completely alternative market-based method of raising capital. The system works just like a public market, but it's limited to 499 investors with $100 million or more (the SEC requires markets with 500 or more to go public). In the past, it would have been nearly impossible to get even 499 investors with that kind of scratch to participate; today, financial technology, coupled with the exploding number of hedge funds and other super-rich capital concentrations, makes it hard to throw a rock in downtown Manhattan without hitting twice that number.

Most observers expected that, because of the limited amount of investors and capital available, stocks of Oaktree Capital Management, the first company to list on GS TrUE, would trade at a discount--that is, sell for less than they were worth. But, in fact, when Oaktree shares became available on May 21, there was no discount at all, and the stock actually rose during the trading day. This has caused other banks to ramp up their own plans for private exchanges. "Basically every single bank is working on its own version of GS TrUE right now," one financial executive said in an interview with Hedge World Daily News. Even NASDAQ, which itself revolutionized the stock market with its arrival in 1971, is nearing completion of Portal, a private exchange specializing in small firms (Portal already operates in a limited capacity for certain types of transactions).

Why would a company want to list on a private exchange? Avoiding regulation is a big reason. Even without Sarbanes-Oxley, companies have an enormous incentive to reduce regulatory oversight, and not always for nefarious reasons--regulatory compliance is very expensive. Being public also requires them to divulge information they'd rather keep secret, everything from sales numbers to research and development. In a world where information is the most lucrative asset, why should a company reveal what it knows--and doesn't? By keeping your stock limited to a small group of in-the-know investors, you can avoid all that.

To the average investor, this seems patently unfair. When a company goes the route of the initial public offering, everyday Americans can get at least a small piece of the next big thing. Everyone who bought shares of Google in August 2004, and held on, is now much richer. Had Google gone with something like GS TrUE, they'd have been shut out. In all fairness, many companies eyeing "initial private offerings" still see themselves going public someday. Then again, that could all change if private exchanges do, as expected, give them access to sufficient capital.

In any case, even a partial decoupling of the corporate world from the public markets could be damaging for the U.S. economy. First, because it means that more companies will operate under looser regulations, and--if recent experience tells us anything--eventually some will abuse them. We don't need another Enron.

But what made Enron palatable, politically, was the fact that it occurred in a market in which individual investors and companies were tightly linked; there was relatively little public anti-capital hysteria, because investors had a financial incentive to continue their faith in the market, and companies had an incentive to reinforce that faith when it was tested. Just five years later, that's decreasingly the case. Hedge funds, private equity, and increasingly complex market transactions are shutting out individuals from the market. And, in a world dominated by private exchanges like GS TrUE, investors would still feel the pain resulting from corporate scandals, but they would have little incentive to believe in the system that enabled them. A massive political backlash would be almost inevitable. And that's hardly good for business.